Monday, December 12, 2011

There is a story in the movie "The Inside Job" about a paper that Fred Mishkin (a Professor at Columbia University and former member of the Board of Governors of the US Federal Reserve) had written on the Icelandic banking system before the crisis. The original title of the paper was "Financial Stability in Iceland" but the paper appeared in his CV as "Financial Instability in Iceland" after the crisis had taken place (and after the movie was released the title was changed back to the original one -- here is a clip of the interview). This clip made me think of the European Stability and Growth Pact that seems to be delivering exactly the opposite of what the name of the title suggests: Instability and lack of growth.

European countries agreed to limit their government deficits and government debt (to 3% and 60% respectively) as part of the Maastricht Treaty that led to the creation of the Euro. The limits were not strictly enforced when the membership decision was made. Some countries (Belgium or Italy) were allowed to be members of EMU with debt levels that were double the established limit (the way this worked was through a loose interpretation of a footnote in the Treaty that allowed countries to be accepted even if their debt was above 60% if the level was close to 60% and there was enough progress in the prior years -- how is 120% close to 60%???).

The constraints on fiscal policy were made more explicit through the Stability and Growth Pact that took the numerical limits one step further and developed a set of more specific interpretations of the limits as well as a process to deal with deviations from the rule. The Pact was a failure with many countries (including Germany) going above the deficit and debt limits. The rules were then rewritten once and just las weekend, during the European summit, there has been a proposal to rewrite them once again. This is what some have referred to as a proposal to create a fiscal union, which is clearly not the case. The proposal is simply about changing the enforcement rules of the Pact.

Academics have written extensively on how the Stability and Growth Pact was poorly designed and could not work (my own work can be found here, here or here. The criticisms can be summarized by the following three points:
- simple numerical limits are "too simple" to deal with fiscal policy. Applying the same rules to every country and every year makes no sense. And the moment you open the door for exceptions then the rules lose their meaning.
- enforcement of the Stability and Growth Pact does not work because the enforcers is the same group as the sinners. The ones imposing fines are the ones who pay for them and collect them. As it has been the case before when many countries are above the limit, fines should be paid by all and collected by all. There is no real sanction here.
- but even if fines are applied, what would happen to a country in trouble (Italy today) if the other European countries imposed a fine on the Italian government? That their deficit would be even larger and it would simply make things worse.

The decision over the weekend was to improve the enforcement of the Stability and Growth Pact and it tries to address the second issue while it ignores the other two. What is worst is that it might not even addressed that issue. The proposal (to be approved) makes the fines automatic. They can only be overturned if a qualified majority of countries agree to it. This is a marginal change that is unlikely to work if many (more so the large) countries are the ones violating the rules. And the proposal ignores the fundamental problems of the Pact.

What is more concerning is that there is still no clarity on the goals of the Pact. The Pact and more so its implementation has always mixed goals such as sustainability with other goals such as coordination of fiscal policy and growth-oriented reforms. But there is no clarity on how these things mix together, and some times they do not. Long-term sustainability is a valid goal, more so given what we are seeing these days. But this does not imply that all countries should have the same fiscal policy all the time. In fact, we want fiscal policy in the short run to be different across countries. Coordination of fiscal policy (understood as one policy stance for all all the time) makes no sense in a monetary union.

And here is where we are today: starting with the concern about long-term sustainability we conclude that short-term austerity is the right policy for all European countries. But imposing coordination combined with a short-term focus on what should be a long-term goal will not deliver stability or growth. It will lead to stagnation in the region and instability in some countries as fiscal policy is not allowed to play a proper countercyclical role.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).